Annual Percentage Rate, or APR, is the interest fee on a form of borrowing. As opposed to a monthly fee, APR is represented as an annual rate. Therefore, it can aid one in understanding the long-term cost of borrowing.
APR can be calculated and applied on the appropriation of a loan, mortgage loan, credit card, investment, and so forth. This guide explores in more detail what APR is, how it works, and how it can be calculated.
How Does APR Work?
APR is expressed as a percentage and represents the yearly cost of a loan or the income earned on an investment. This means that the APR will calculate what percentage of the loan principal you will pay each year, taking monthly payments and fees into account.
The APR is a bottom-line number that borrowers can use to compare loan options from different lenders, credit cards, or investment products.
How to Calculate APR
APR is calculated using the following steps:
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Determining the interest rate and adding the administrative fees
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Dividing the total amount by the length of the loan term
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Multiplying the number from step two by 365
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Multiplying the number from step three by 100
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Converting the number from step four to a percentage
In other words, by multiplying the periodic interest rate by the number of periods in the year it was applied.
Types of APR
There are two types of APR – fixed and variable. These are explained in more detail below:
What Is Fixed APR?
With fixed APR, there is no variation in the interest rate, and the amount paid per year remains the same. This means that the principal amount borrowed does not change, nor does the APR calculation based on the interest rate.
What Does Variable APR Mean?
Conversely, variable APR is subject to change because the interest rate applied to the principal varies from time to time. For example, if there is an upward surge in the interest rate, the borrower will pay more.
Fixed vs Variable: Advantages and Disadvantages
A fixed-rate can help borrowers calculate their repayments more easily as it will remain constant. This can help reduce the risk a borrower may face of paying an unexpectedly higher monthly payment.
But, a fixed rate also removes any possibility of a borrower benefiting from lower monthly payments should the market rate go down.
A variable rate interest also allows the lender to increase or decrease the interest rate at any point during a credit agreement, typically as a result of fluctuations in the market base rate. But, this also means the borrower will risk being unable to afford payments if the interest rates rise.
Disadvantages of Annual Percentage Rate (APR)
As discussed, there are benefits to what APR can showcase. However, there are also disadvantages to APR. First, APR may not always accurately reflect the total cost of borrowing as it may understate the actual cost of a loan . This is because the calculations assume long-term repayment schedules, and the costs and fees are spread too thin with APR calculations for loans that are repaid faster or have shorter repayment periods.
Furthermore, APR may not be accurate when taking into account Adjustable-Rate Mortgages (ARMs). This is because APR estimations typically assume a constant interest rate, often basing its final number on fixed rates. This can, again, cause a severe underestimation of the actual borrowing costs.
The APR can also be particularly tricky when it comes to calculating the interest rate of mortgages. Mortgage APRs may not take into account other additional charges, such as appraisals, titles, attorneys and notaries. Again, this means the final figure may be an understatement of the true costs.
This disadvantage of APR can make it difficult to compare similar products because the fees included or excluded differ from place to place. In order to accurately compare multiple offers, a potential borrower must determine which of these fees are included and continue to calculate APR using the nominal interest rate and other cost information.
